1 BORROWERS - - PDF document

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• David McLaughry, FCAS, MAAA

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• The Casualty Actuarial Society is committed to adhering strictly to the letter and spirit
• f the antitrust laws. Seminars conducted under the auspices of the CAS are designed

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prevent any written or verbal discussions that appear to violate these laws, and to adhere in every respect to the CAS antitrust compliance policy.

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• Overview of Mortgage Guaranty Insurance (“MI”).
• Brief history of MI.
• How the industry has fared since 1980.
• What went wrong?
• Fallout from the crisis.

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MI PROVIDER

• loans. MI is required for

• Provides a form of credit risk transfer to protect financial

• It does not insure the borrower.
• It insures the financial institution’s loss due to

• Covers mortgage loans with LTV ratios higher than 80%.
• Aims to provide stability and soundness to the housing

• Purchase home with lower down payment.
• Afford a larger home.
• Increase home ownership rate.

• Reduces credit risk exposure.
• Provides independent secondary underwriting review.
• Expands mortgage markets.
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• The policy insures a lender—who may pass the premium cost directly to the

borrower—against borrower default on a mortgage loan.

• Coverage spans the life of a loan and is generally cancellable only under the following

circumstances:

• MI premium is not paid.
• The loan amortizes below an LTV of 78%, under the Homeowners Protection Act (HPA).
• The loan prepays completely.
• Insurers provide proportional coverage in the U.S.
• Insured risk amount (“risk”) = (loan amount) x (coverage percentage).
• To settle a claim, the insurer chooses from three options:
• Approve a short sale of the property and pay remaining deficiency.
• Purchase the property for the balance due and sell the property.
• Pay “optional” settlement equal to (coverage percentage) x (loan amount) + (covered fees).
• The claim payment is made to the investor.
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Typically, 25% private MI coverage is provided on a 90% LTV loan. ($90,000 X .25 = $22,500)

Fannie Mae / Freddie Mac layer (the lender may also hold the loan in its portfolio).

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• The policy premium can be paid by the lender or can be passed through to the

borrower—in the U.S., borrower-paid MI is the predominant form of insurance.

• Several premium payment options are typically available.
• Single premium.
• Annual installment, based upon original or declining balance.
• Monthly installment, based upon original or declining balance.
• Split premium, a hybrid premium type in which the up-front rate is typically higher than the

installment rate.

• Single premiums are earned based on a prescribed earnings pattern.
• Installment premiums are typically earned over the installment period.
• Installment premiums cannot be changed once the policy is written.
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• Loss reserves are established at the date of the first missed payment

(the “Accident Date”).

• Servicers typically report delinquent loans to the MI provider after a loan has been

delinquent for 60 days.

• Given the length of time it takes to complete the foreclosure process, it typically takes

1.5–2.0 years before a claim payment is made.

• The short reporting lag results in much larger reserves for known delinquent loans

(“Case Reserves”) than for IBNR delinquent loans.

• A mismatch of premiums and losses occurs,

particularly for installment premiums:

• No explicit reserve for future delinquencies,

except if a Premium Deficiency Reserve is indicated.

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• First-lien mortgage insurers are monoline—they insure only first-lien home mortgages.
• MI is commercial insurance—customers are financial institutions

(banks, credit unions, etc.).

• Borrowers are neither a party to nor a beneficiary of the insurance.
• Once a mortgage insurer has issued insurance, it can generally only cancel for

non-payment of premium.

• Cannot re-underwrite at any time during coverage.
• The rate / premium charged remains fixed throughout the life of the coverage.
• Cannot re-rate during the term of coverage.
• The mortgage insurer must maintain a statutory contingency reserve of

50% of earned premium.

• If the coverage on the loan exceeds 25%, the mortgage insurer must reinsure

any coverage above 25%.

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• Written on a non-monoline basis prior to the Great Depression.
• Fifty mortgage insurers were founded in the early 1900s;

the industry was profitable until the 1930s

• During the Great Depression, all companies went under

(all 50 were liquidated by 1950).

• Largest insurance company liquidation the New York Department of Insurance had ever done.
• In 1934, the FHA was established to fill the void; Fannie Mae was established in 1938.
• Private Mortgage Insurance was outlawed throughout the U.S. until the 1950s.
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Safeguards were built into state laws beginning in 1956; the resulting NAIC model law:

• Recognized the catastrophic nature of MI.
• Established the requirement of a Contingency Reserve (segregated surplus).
• Contingency Reserves are initially established at 50% of the earned premium amount.
• Must be held for 10 years and are only allowed to be released under certain conditions,

typically driven by incurred loss levels.

• Required that first-lien MI carriers be monoline—only insure first-lien home mortgages.
• Capital requirements:
• Certain states require risk-to-capital levels of less than 25:1.
• The GSEs and rating agencies require even lower risk-to-capital ratios in order to maintain

eligibility to write MI and to sustain investment grade ratings, respectively.

• The net result is that MI companies maintain premium-to-surplus ratios of ~0.30.
• Investment restrictions: MI companies cannot originate mortgages or

invest in mortgages or real estate.

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• At least 11 mortgage insurance groups were formed between 1957 and 1987.
• The industry suffered significant losses in 1980s and 2000s.
• Flagship carriers of at least four groups ceased writing new business by 1990.
• Of the seven mortgage insurers in business in 2008, three have gone into runoff.
• Those three are paying their claims at the 50–60% level and issue a deferred payment
• bligation for the remainder.
• MI companies that survived are still struggling with legacy exposure to

loans insured prior to 2009.

• Two new companies have recently entered the market (Essent and NMI).

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• 50%
• 40%
• 30%
• 20%
• 10%

MI Industry Performance 1977-2012

Average ROE 1977–2012 = 9.4%

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Local shocks drive MI losses, often masked by aggregate trends.

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Risk Level

Sample MI Cycle - Risk Distribution

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• Industry accommodated risky lender behavior, rather than safeguard against it:
• Delegated underwriting model.
• Bulk and Pool coverage.
• Product expansion (low-doc, interest-only, ARMs, etc.) .
• Minimal pricing segmentation.
• The mortgage system failed on many fronts, and mortgage insurers

participated in that failure.

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• MI failures/ratings downgrades.
• Sharp drop in private MI market share.
• FHA/VA share of insured loans rose from less than 25% in 2007 to more than 80% in 2009.
• Lender dissatisfaction: rescinded coverage and denied claims.
• Profits of many years wiped out.
• Future of industry regulation and government participation uncertain.

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Questions?